IRS Regulation 409A really sucks. While I’m probably now on some audit watch list as a result of speaking my mind, there really isn’t any other way to state it. Jason Mendelson and I were bitching about this today as we pondered how to deal with it and decided that we might as well try to constructively air our thoughts (and help educate our entrepreneurial and venture brethern on some of the issues) via a 409A Series (similar to our Term Sheet and Letter of Intent series). Remember – we aren’t lawyers (ok – Jason is…) and this isn’t legal advice – just the thoughts and opinions of two guys dealing with this stuff everyday.

In case you missed it, proposed IRS Regulation 409A, dealing with deferred compensation, is making everyone in the startup community run around like chickens with their heads cut off. It’s a broad regulation, but in a nutshell, for private companies it redefines the way companies determine fair market value in granting stock options. In the “old days” (before I was 40 years old) the board would spend time and make a good faith determination what the fair market value was and grant options. Now, companies must formally value their common stock options (by one of two prescribed methods that we’ll get to later) or risk the penalties should they be wrong with their option pricing. Please note that this regulation also affects public companies, venture capitalists, severance contracts, any sort of deferred compensation, etc., but we’re only going to focus on the private company option pricing nightmare.

Because everyone likes the punch line, the simple answer to “what are the penalties?” is this: The penalty for undervaluing options is that the option holder gets taxed at normal income rates on the “spread” (difference between the grant strike price and what the IRS deems the “correct” value) as if it was income given to him by the company PLUS an additional 20% tax on top of this in further penalties. Furthermore, the company gets penalized on withholdings it should have made on this additional “income” it provided to the employee.

But wait, it gets better. Did we mention that these are only proposed regs, but the IRS says everyone must comply with them immediately as if they will be adopted and oh yeah…. they’re retroactive also and any stock option that still has vesting left as of January 1, 2005 is subject to the regs. Yes, if you granted or received an option in mid-2001 with typical 4 year vesting, congratulations, you are subject to 409A.

Basically, everyone involved gets fucked.

Interested? Scared? Reconsidering a new career as a 409A valuation expert? In this series we’ll take your through some detail on the joys of 409A. If you are a masochist and want some good reading, Cooley Godward has a good overview online as does O’Melveny & Myers.

In the mean time, sleep well. While we wish we could spray some Formula 409 on this and make it go away, we know the value of facing reality and will provide some addition information in our next post.